What are the characteristics of an efficient capital market?

Companies use capital markets, such as stock exchanges, to raise capital.

A capital market can be defined narrowly as the market for investors to trade securities and broadly as the market for companies and governments to raise money or capital. An efficient capital market is one in which prices change rapidly in response to changes in demand and supply, thus producing “fair” prices at any given time. In addition to information, an efficient capital market will generally require liquidity through a large enough collection of traders to accurately influence prices.

The capital market consists of securities, both debt products such as bonds and equity products such as stocks. It is usually defined as securities where the issuer will have more than one year to return the initial payment. This means that short-term securities, such as Treasury bills, are instead traded in a different type of market, often called a money market.

There are two main forms of capital markets. The primary market is where companies and governments create and sell bonds, usually through an underwriter. The secondary market is one where traders buy and sell these bonds from each other, which means that the investor who ends up redeeming a bond or receiving dividends on the stock is often not the investor who originally paid the issuer money.

An efficient capital market is generally defined by the availability and accuracy of information about securities and their prices. Economic theories of the market are generally based on the idea that every trader has complete information about the securities available and the price demanded, along with any other details that may be relevant, such as past market behavior, the performance of the company issuing the shares. , or the probability that an issuer of debt securities will repay the money as promised. The more efficient a capital market, the closer the real situation will be to this hypothetical situation. The idea is that the more efficient the market, the more informed the judgments and decisions of investors will be, and thus money will be allocated in the most productive way overall.

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A rating provides three levels of efficiency. A weak and efficient capital market is one in which only information about the past is reflected in bond prices. A semi-strong efficient market is one in which current publicly available information is known to all investors and reflected in prices. A strong and efficient market is one in which all information is known to investors, even that which is not publicly available; this is effectively the situation assumed by market theories, but unlikely in the real world.

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